Liquidity Ratio

• All current assets are eventually transformed into cash.
• All current liabilities eventually have to be paid for with cash.
• The source for the cash, which is needed to pay current liabilities, is current assets.
• There should, therefore, always be sufficient current assets in relation to the level of current liabilities.
• This relationship is called liquidity.

Liquidity refers to a firm's ability to meet its obligations over the short term, that is to have the necessary cash available from cash reserves, cash sales and debtors to pay for sufficient stock and to make payments due to creditors.

Click here to view a video that explains the ratio analysis.

Two ratios are commonly used to measure a firm's liquidity:

Current ratio = current assets ÷ current liabilities

= 24 000 000 ÷ 10 000 000

= 2.4 times

It gives an indication of the company's ability to meet its obligations over the short term.

(also called the liquidity ratio). Jimco (pg 52) had R2.40 in current assets for every R1.00 in current liabilities. This compares favourably with the rule of thumb of 2 for the current ratio.

Quick ratio = (current assets - stock) ÷ current liabilities

= (24 000 000 - 12 000 000) ÷ 10 000 000

= 1.2 times

This is a stricter measure of liquidity than the current ratio and is also known as the acid test. Stock first has to be sold before it can be converted to cash. Jimco had R1.20 of cash or cash claims (debtors) for every R1.00 in current liabilities. This does compare favourably with the rule of thumb of 1 for the quick ratio. Investment in stock may be too high if this ratio is out of line, especially if the previous one was in line.

Click here to view a video that explains the current ratio.